Thursday, December 18, 2014

Putin’s Year of Defiance and Miscalculation - Kremlin Misjudged Bite of Sanctions, Then Oil Plunged

As Western governments seethed last spring over Russia’s takeover of the Crimea region in Ukraine, Vladimir Putin told advisers that the world eventually would accept the audacious move. The Kremlin was confident the economic costs of Western sanctions, though substantial, would be tolerable for the world’s ninth-largest economy.

For much of the year, the Russian president’s gamble seemed to pay off. “His forecasts have come true,” Alexei Kudrin, a former finance minister and longtime Putin adviser, said in May. “A lot of people have come to terms with Crimea now, at least informally.”

Mr. Putin also seemed confident, according to people who spoke to him at the time, that the deep ties he had nurtured for years with major trade partners like Germany would limit the fallout.

Those calculations turned out to be dead wrong. Broader sanctions choked off Russia’s access to Western capital and technology, tipping the economy toward recession. Then came a second blow that neither Western governments nor Russia could have anticipated: The price of oil—the lifeblood of Russia’s economy—plunged 40% since midsummer, magnifying the effect of sanctions and sending the ruble into a tailspin. The slide turned into a full-on currency crisis on Tuesday as the ruble dropped as much as 20% against the dollar.

As the problems intensify, Mr. Putin’s miscalculations have restricted his options. After largely ignoring the economic costs of the conflict for most of the year, freezing out liberal aides who tried to warn of the impact, he has begun trying recently to win back the confidence of business and revive the economy, people close to the process say. Mr. Putin is expected to be questioned about the ruble crisis during his annual news conference on Thursday.

The Ukraine conflict has produced the deepest breach between Moscow and the West since the Cold War. A notable casualty has been Mr. Putin’s relationship with Angela Merkel , who emerged as Europe’s most powerful leader in large part because of Germany’s relative economic strength.

As recently as a year ago, the German chancellor was one of Mr. Putin’s most reliable Western partners, offsetting more anti-Moscow voices such as the U.S. and Poland. Now, she is keeping the rest of Europe in line behind sanctions and warning of the danger she says Mr. Putin poses to security across the continent.

“We are suddenly confronted with a conflict that goes, so to speak, to the core of our values,” Ms. Merkel said in Sydney, Australia, in November. “Old thinking in terms of spheres of influence, in which international law is trampled upon, cannot be allowed to assert itself.”

Mr. Putin’s rhetoric on Ukraine seems to have softened in recent weeks as state-run pollsters in Russia report growing alarm over the falling ruble and rising prices. “Whenever they start to feel danger in their bones—we saw it in [the financial crisis of] 2008—they start looking for the liberals to help,” a senior Russian legislator said of the hard-liners in Mr. Putin’s inner circle.

The Kremlin declined to comment for this article.

With Mr. Putin’s government warning that significant relief from sanctions could be more than a year away, there is little chance of avoiding surging inflation and further declines in the ruble. This week’s currency crisis has increased the urgency, making a steep recession next year all but inevitable.

The Kremlin appears to have written off hope of rapprochement with the Obama administration, which has pressed the European Union to back strong sanctions. And patching things up with Ms. Merkel doesn’t look any easier.

“Russia has become unpredictable, which is the biggest threat to partnership,” said Gernot Erler, the German government’s coordinator for Eastern European affairs. “We don’t know at all what Russia’s goals are.”

A year ago, it looked as though German relations with Moscow were warming. The revelations of National Security Agency leaker Edward Snowden helped turn public opinion against Washington in privacy-sensitive Germany. Last December, Ms. Merkel formed a new government with the Social Democrats, historically a party friendly to Russia. Foreign Minister Frank-Walter Steinmeier said the EU may have underestimated Ukraine’s economic and “historic emotional” ties to Russia.

Russia annexed the Crimea Peninsula in March. In the early weeks of the crisis, Ms. Merkel remained cautious about tough sanctions, fearing they might prevent a way out for Moscow.
The first round of sanctions mainly affected officials and businessmen with ties to Mr. Putin. Opening a meeting with aides after they were announced, Mr. Putin didn’t even mention the possible economic impact, calling instead for faster growth. But after state-television cameras were ushered out, officials expressed concern.

Mr. Kudrin, the former finance minister and longtime Putin ally who attended, said that even if the sanctions were limited just to individuals, they still would hit growth hard. Wider sanctions on state banks—they would come in the summer—would be much more painful, he warned, fueling capital flight, sapping investment and bruising the ruble.

At the time, the government was expecting the economy to grow and inflation to remain under control. Mr. Kudrin estimated at the time that the Ukraine crisis cut about one percentage point off GDP growth—about what the government spent on the Sochi Olympics. Over two to three years, the bill might rise to $200 billion—“not catastrophic,” as he put it later.

His warning didn’t dissuade Mr. Putin and the rest of the leadership from confronting the West. “They all understood everything,” Mr. Kudrin recalled later. “They’re ready to pay that price.”

When additional sanctions came during the spring, some government officials began to recognize that the informal effect—chilling business activity—was more painful than expected. But their appeals to Mr. Putin were largely ignored, according to people close to the discussions.

“There was a sense that foreign policy was the priority and that it could be conducted without doing much harm to the economy,” said one Kremlin adviser.

As the ground fighting in Ukraine worsened over the summer, Germany’s resolve to take on the Kremlin stiffened. The U.S. had been pressing the Europeans to do so for months. Some German officials were concerned that earlier sanctions hadn’t been tough enough.

Ms. Merkel and Mr. Putin held lengthy, often combative phone calls, according to German officials familiar with the conversations.

Western intelligence suggested Russia was supplying the separatists with weapons and appeared to be coordinating their operations. Mr. Putin said he had nothing to do with it, and told Ms. Merkel that Ukraine was the kind of place where abandoned tanks could be found on farms, according to one official familiar with the discussions.

Ms. Merkel’s office had the German spy agency, the BND, draw up biographies of rebel leaders, most of whom hailed from Russia. Over the phone, Ms. Merkel repeatedly confronted Mr. Putin with evidence that the rebel leaders had ties to Russian intelligence, according to German officials. Mr. Putin, who rarely raised his voice during the discussions, denied he had any influence over the rebels. At important points, he would shift from Russian—which Ms. Merkel learned growing up in Communist East Germany—to German, which Mr. Putin speaks well.

German diplomats thought the downing of Malaysia Airlines Flight 17 on July 17, killing all 298 people aboard, might open a path to calming the conflict. But Mr. Putin publicly denied the rebels had shot down the plane, repeating theories broadcast by Russian television that the Ukrainians were responsible.

He told Ms. Merkel over the phone that his own plane was in the air over Europe at the time and that the shootdown may have been an assassination attempt. “I could have been a victim, too,” he said, according to one person knowledgeable about the call.

The first round of sanctions mainly affected officials and businessmen with ties to Mr. Putin. Opening a meeting with aides after they were announced, Mr. Putin didn’t even mention the possible economic impact, calling instead for faster growth. But after state-television cameras were ushered out, officials expressed concern.

Mr. Kudrin, the former finance minister and longtime Putin ally who attended, said that even if the sanctions were limited just to individuals, they still would hit growth hard. Wider sanctions on state banks—they would come in the summer—would be much more painful, he warned, fueling capital flight, sapping investment and bruising the ruble.

At the time, the government was expecting the economy to grow and inflation to remain under control. Mr. Kudrin estimated at the time that the Ukraine crisis cut about one percentage point off GDP growth—about what the government spent on the Sochi Olympics. Over two to three years, the bill might rise to $200 billion—“not catastrophic,” as he put it later.

His warning didn’t dissuade Mr. Putin and the rest of the leadership from confronting the West. “They all understood everything,” Mr. Kudrin recalled later. “They’re ready to pay that price.”

When additional sanctions came during the spring, some government officials began to recognize that the informal effect—chilling business activity—was more painful than expected. But their appeals to Mr. Putin were largely ignored, according to people close to the discussions.

“There was a sense that foreign policy was the priority and that it could be conducted without doing much harm to the economy,” said one Kremlin adviser.

As the ground fighting in Ukraine worsened over the summer, Germany’s resolve to take on the Kremlin stiffened. The U.S. had been pressing the Europeans to do so for months. Some German officials were concerned that earlier sanctions hadn’t been tough enough.

Ms. Merkel and Mr. Putin held lengthy, often combative phone calls, according to German officials familiar with the conversations.

Western intelligence suggested Russia was supplying the separatists with weapons and appeared to be coordinating their operations. Mr. Putin said he had nothing to do with it, and told Ms. Merkel that Ukraine was the kind of place where abandoned tanks could be found on farms, according to one official familiar with the discussions.

Ms. Merkel’s office had the German spy agency, the BND, draw up biographies of rebel leaders, most of whom hailed from Russia. Over the phone, Ms. Merkel repeatedly confronted Mr. Putin with evidence that the rebel leaders had ties to Russian intelligence, according to German officials. Mr. Putin, who rarely raised his voice during the discussions, denied he had any influence over the rebels. At important points, he would shift from Russian—which Ms. Merkel learned growing up in Communist East Germany—to German, which Mr. Putin speaks well.

German diplomats thought the downing of Malaysia Airlines Flight 17 on July 17, killing all 298 people aboard, might open a path to calming the conflict. But Mr. Putin publicly denied the rebels had shot down the plane, repeating theories broadcast by Russian television that the Ukrainians were responsible.

He told Ms. Merkel over the phone that his own plane was in the air over Europe at the time and that the shootdown may have been an assassination attempt. “I could have been a victim, too,” he said, according to one person knowledgeable about the call.

German officials analyzed Mr. Putin’s flight path and didn’t buy the contention, according to one person familiar with the effort.

Convinced that Mr. Putin wasn’t pushing the rebels to stop fighting, Ms. Merkel corralled the other 27 European Union member states to follow the U.S. and back the first sanctions against sectors of the Russian economy. They amounted to a body blow to Russia, whose largest banks and companies depended on Western financing and technology.

The Kremlin responded with sanctions of its own against food imports from the West, hitting some European farmers hard.

Inside Russia, pro-market advisers who had warned about too much confrontation with the West, including Mr. Kudrin, found themselves largely frozen out, according to people close to them. Mr. Kudrin lamented publicly that he rarely was consulted by the Kremlin anymore and that business was alarmed by Moscow’s anti-Western turn.

A tight circle of mostly hard-line advisers, including Defense Minister Sergei Shoigu and Federal Security Service head Alexander Bortnikov, had become Mr. Putin’s closest confidantes, according to Kremlin insiders and diplomats.

In early September, even though pro-Russian rebels had just signed a cease-fire agreement with Ukraine, Ms. Merkel pushed for a second round of economic sanctions. Ms. Merkel and other Western leaders said Russia was doing little to carry out the terms of the cease-fire agreement, including preventing weapons and fighters from crossing the Russian border into eastern Ukraine.

In early October, German Gref, chief executive of Russia’s state-run Sberbank and the pro-market author of Mr. Putin’s economic programs, lashed out in public at an October conference where the president was to speak.

Warning that defying “the laws of economic development” would bring Russia to collapse as it did the Soviet Union, Mr. Gref ridiculed government policies for replacing sanctioned products with domestic ones. “You cannot motivate people through the Gulag, like in the Soviet Union,” he said to nervous applause.

Mr. Putin shrugged off the comments when asked about them later. The government still was expecting Europe to lift sanctions by the middle of 2015 and for oil prices to recover to $100 a barrel, Russian officials said at the time.

Within weeks, an additional plunge in oil prices forced the Kremlin to reassess its plans.

After spending $30 billion in October in an unsuccessful effort to slow the ruble’s slide, the central bank announced in early November it would let the Russian currency float freely to save its reserves. Hard-line advisers in the Kremlin, including economic aide Sergei Glaziev, had called for fixing the rate and restricting access to foreign currency. But Mr. Putin rejected that advice as risking even more economic disruption. The central bank’s move triggered a slide in the currency.

“In late November and early December, the authorities realized there would be a crisis,” said one Kremlin adviser. Just before Mr. Putin’s state-of-the-nation address on Dec. 4, the Economy Ministry revised its forecast. Russia would get no relief from low oil prices or sanctions in 2015, the new forecast said, which would drive the country into recession.

After other officials criticized the outlook as too gloomy, it quickly disappeared from the ministry’s website.

In his speech, Mr. Putin announced steps to improve the business climate. But he also warned that the Kremlin knew who the “speculators” were who were selling the ruble, which did little to reassure investors or offset market fears.

Tensions exploded this week. The currency plunge left Russians racing to convert their savings out of rubles. An emergency rate hike by the central bank did little to stop the selling.

Frictions surfaced between liberals and hard-liners. Mr. Kudrin took to Twitter to say the market plunge was the result not just of sanctions and low oil prices but “also a lack of confidence in the government’s economic measures.” He criticized a bailout deal for the state oil company, prompting the company’s CEO to denounce him as a “provocateur.”

Amid the deepening crisis, Western diplomats have reported hints of softening in the Kremlin’s position on Ukraine, though they say it is too early to declare a shift. Late Tuesday, Mr. Putin joined a conference call with Ms. Merkel, French President François Hollande and Ukrainian President Petro Poroshenko to discuss new talks to stabilize the cease-fire in eastern Ukraine.

But after a year of diplomatic wrangling, German officials say they have little reason to believe the Kremlin’s policies will change quickly.

The Germans say that continuing to talk to the Kremlin is important for affording Mr. Putin a way out of the crisis. Some German diplomats worry that with the Russian economy deteriorating, Mr. Putin may be tempted to escalate the conflict in Ukraine to distract his countrymen from problems at home.

In November, Ms. Merkel met with Mr. Putin at the Hilton hotel in Brisbane, Australia, talking and sipping wine for more than three hours as their aides waited outside the room. Ms. Merkel hoped that confronting him in a more relaxed format could lead to progress. It didn’t.

Just over a day later, Ms. Merkel delivered some of her angriest remarks of the crisis.

“We can no longer simply hold speeches at memorial events,” Ms. Merkel said, referring to the many commemorations of World War I, World War II and the Cold War held in Europe this year. “Now we have to somehow show what we have learned from all this.”